What's Next - Strategy & Competition December 29, 2009, 5:17PM EST

Netflix vs. the Hollywood Studios

The subscription service wants to deliver films directly to your TV or PC. Studio heads are balking

By Ronald Grover, Adam Satariano and Ari Levy

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Netflix bypassed the studios to win digital access to Spider-Man 3 and Ratatouille Sony Pictures/Courtesy Everett Collection

Walt Disney Co./Courtesy Everett Collection

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Ted Sarandos isn't likely to accept studios' payment plan for streaming video John M. Heller/Getty Images

In the paranoid precincts of Hollywood, a question has been making the rounds: Is Ted Sarandos friend or foe?

Sarandos is the content chief at Netflix (NFLX) and one of the studios' most devoted customers. Each year, on behalf of his company, he buys an estimated $240 million worth of DVDs that Netflix then mails out to its subscribers. All was going well until Sarandos last year cut a deal with Starz, the movie channel, to stream Walt Disney (DIS) and Sony (SNE) films, including Ratatouille and Spider-Man 3, to subscribers' PCs, Web-connected TVs, and game consoles. For an industry that jealously protects its right to license movies to the highest bidder, the move amounted to an end run.

Why would Sarandos risk angering Hollywood? Because Netflix, having prospered in the DVD rental business, needs to position itself for a future when viewers will be able to watch any movie or TV show they want instantly on their PC, TV, mobile phone, game console, or tablet. Netflix has a powerful brand and slick streaming technology. But to stay relevant the company needs access to much more of the studios' digital content. Otherwise Netflix could be overwhelmed by deep-pocketed rivals—from the cable companies to Amazon.com (AMZN), Google (GOOG), and Apple (AAPL) to the studios themselves.

Lately, Sarandos, 45, has been shuttling between Hollywood power lunches, film festivals, and awards dinners, telling anyone who will listen that Netflix is not the enemy but a bridge to the future. "Don't forget, the studios have fought every form of home entertainment," Sarandos wrote in an e-mail to Bloomberg BusinessWeek. "And TV and DVDs have become their largest sources of revenue and profits."

Hedging Bets

Netflix's 11-year-old DVD-by-mail model has already transformed the movie rental business. And Sarandos, who has worked for Netflix since 2000 and last year pulled down a $1.1 million salary, played a big role in the company's success. It was Sarandos, working from a Beverly Hills office, who persuaded the studios to allow Netflix to buy DVDs for much less than, say, Wal-Mart Stores (WMT). The cut-rate deal allowed Netflix to offer subscriptions for as little as $8.99 a month and grow into the largest mail-order DVD renter of its kind. This year Netflix is on track to earn some $111 million on sales of $1.67 billion, a 22% gain over 2008. Its stock is up 90% this year—partly on rumors that Amazon or Apple might buy the company. CEO Reed Hastings says he expects to be mailing out DVDs 20 years from now.

That hasn't prevented Hastings from hedging his bets, however. Three years ago Netflix launched Watch Instantly, an online service on its existing Web site. With a couple of mouse clicks subscribers can watch a limited selection of movies and TV shows right away rather than wait for them to arrive in one of Netflix's trademark red envelopes. The company says 42% of its 11.1 million subscribers have tried the service, twice as many as last year. Still, Netflix does not disclose how often its customers use the streaming service, and analysts believe that it is tiny next to the DVD business.

To turn the service into the real deal, Netflix will have to build a compelling online library. Right now Watch Instantly features only 17,000 films and TV shows, compared with Netflix's 100,000 or so titles on DVD.